Throughout the history of IMF lending, the institution has had preferred creditor status – that is, distressed countries borrowing from the IMF are expected to give priority to meeting their obligations to the IMF over those to other creditors. This status is a defining characteristic of the IMF’s role in financial crises – it provides a high degree of confidence that IMF resources are safe when other creditors face substantial uncertainty about full repayment.
The case for the IMF’s preferred status is not often questioned. There is something of a mantra within the Fund and among many Fund watchers that the status is appropriate to protect the resources of an institution that is the closest thing to an international lender of last resort. The preferred status permits the IMF to help distressed countries formulate policies necessary for restoring economic stability and a manageable level of debt, and to have credibility-enhancing ‘skin in the game’ while putting its own financial resources at minimal risk. Moreover, the IMF lends at very low interest rates when risk premia are typically very high – the preferred status is, in a sense, compensation. It is argued that without it, the Fund would have to be more cautious to whom it lends and could, therefore, be reluctant to play a full role in the most severe debt crises.
Yet, this case rests on the credibility of the IMF in ensuring that distressed countries to which it lends have made policy changes (including debt restructuring where necessary) that will expeditiously stabilize the economy and catalyse market lending. But in 2010, when the IMF committed €30 billion to Greece – the largest amount ever to a single country – it introduced a permanent option to waive the requirement that borrowing countries be on a path to debt sustainability.
The option of waiving the criterion on debt sustainability while maintaining the creditor status raises several questions.
- By insulating the Fund’s resources from any future debt restructuring, does the preference reduce the Fund’s accountability and introduce moral hazard into lending decisions?
- By facilitating IMF financing of pre-restructuring bail-outs of some private creditors, does the status, in fact, have the opposite effect to the intended catalytic role of the IMF?
- Finally, if the Fund lends with preference when restructurings are ultimately needed, how long will markets desist from challenging the preferred status during mid-program debt restructuring?
In sum, are the traditional arguments for a preferred creditor status still valid after the introduction (and use) of an option for waiving the requirement that IMF programs be highly likely to produce debt sustainability?
The IMF’s preferred creditor status – the facts and the record
The IMF’s preferred status is de facto rather than de jure. The conventional wisdom within the international community is that the creditor status, along with conditionality on the agreed policy program of a borrower, is a critical part of the Fund’s mandate to require ‘adequate safeguards’ on its outstanding credits. However, it is an agreed principle among, rather than a legal requirement on, its members.
The preferred status is not mentioned in the IMF’s Articles of Agreement. Indeed, Martha (1990) argues that the original Articles of Agreement implicitly envisage that at least some private creditors should have precedence over the IMF in a country’s debt servicing. Only in 1988 did PCS receive a formal – though still not legally binding – endorsement from the IMF Board of Governors’ Interim Committee.1 Then, in the context of efforts to address a growing problem with arrears of low-income countries to the IMF, the committee “urged all members within the limits of their laws to treat the Fund as a preferred creditor.”
More recently, the de facto/de jure distinction has attracted attention for its possible relevance to determining whether drawing on IMF resources constitutes a debt restructuring owing to the subordination of existing bondholder claims (Cotterill 2012). The preferred status also affects the provision of resources to the IMF. Member countries have several different arrangements for funding and accounting for their quota subscriptions (or outright loans) to the IMF, but many are heavily influenced by the (perceived) protection that comes from the preference.
Throughout the IMF’s history, the creditor status has worked reasonably well. Rarely has the IMF not been paid on time, and even less frequently has it not been fully repaid. Apart from what is likely to be a genuine commitment to the spirit of the de facto preferred creditor, two specific factors mitigate against reneging on obligations to the IMF:
- First, delayed repayment, let alone default, to the Fund casts countries in pariah status.
- Second, when a country’s return to stability takes longer than initially envisaged and the threat of arrears is acute, the Fund works with the country to put a follow-up lending arrangement in place. In effect, this is evergreening, albeit in the context of a new program to strengthen policy adjustments to ensure that economic stability and the capacity to repay the Fund are restored.
The major weakness in the record of countries repaying the Fund was among low-income borrowers during the 1980s. In the early 1980s, a bulge in lending to low-income countries gave way to a spate of arrears during the late 1980s and early 1990s. Boughton (2001) points to “conventional wisdom” that the arrears problem arose from “the IMF under political pressure…being lax in controlling its lending in the early 1980s.” Addressing these arrears cases brought forth a significant effort to set penalties (ranging from ‘naming and shaming’ to ineligibility to draw on Fund resources to potential expulsion from the Fund) and establish procedures for assisting countries in arrears. The latter involved strengthening adjustment programs, finding official creditors to provide financing to reduce arrears to the Fund, and then providing fresh IMF funding through newly established concessional facilities at the IMF – in effect, restructuring IMF credits.
The Eurozone crisis – a game-changer?
The Eurozone crisis put the role of the IMF’s preferred creditor status in a new light. At least implicitly, tension has always existed between two possible effects of the status:
- On the one hand, facilitating the IMF’s role in supporting corrective policy programs in distressed countries with its own resources; and
- On the other, introducing moral hazard into IMF lending decisions when political pressures to lend are strong.
Historically, the former has dominated, in large part because the IMF has had a reasonably strong framework constraining its discretion. But after that framework was weakened to permit the IMF to lend in the Eurozone crisis, the latter – the preferred creditor as a source of moral hazard – takes on greater weight.
The scope for moral hazard stemming from the creditor status was evident from the beginning of the IMF’s involvement in the Eurozone crisis. Publicly available records indicate that some member countries asked for explicit confirmation of the IMF’s preferred status prior to approving the loan to Greece in May 2010: “The US chair (supported by Brazil and Switzerland) emphasized that, because of the [preferred creditor status], the Fund’s loan will be senior to bilateral loans from EU countries pooled by the European Commission. Staff confirmed that this is the case, because of the public good nature of Fund financing, and in accordance with Paris Club’s rules” (Catan and Talley 2013). The request for confirmation of the Fund’s preferred status revealed concerns that without an up-front debt restructuring, the program of policies would not return Greece to stability.
Preventing loans in such circumstances was precisely the objective of the four criteria for exceptional access adopted in 2002 (see Schadler 2013). The criteria require that:
- The borrowing country experiences “exceptional balance-of-payments pressures”;
- A “rigorous and systematic analysis indicates that there is a high probability that the member’s public debt is sustainable in the medium term”;
- “The member has prospects for gaining or regaining access to private capital markets within the time frame when Fund resources are outstanding”;
- The country’s policy program “provides reasonably strong prospects of success”.
However, in approving the lending arrangement for Greece, the IMF’s Executive Board introduced an option for waiving the second criterion – that requiring a high probability that the program of policies would return public debt to a sustainable level.
The primary concern of Executive Directors requesting clarification of the IMF’s preferred status therefore was that without a reiteration of the commitment to it, the significant probability of a debt restructuring would put the Fund’s resources at an unacceptable risk.
A second concern behind the call for reaffirmation of the IMF’s preferred creditor was the position of IMF credits relative to official European lending to Greece. Indeed, obligations to the European Central Bank (ECB) and national central banks were excluded from the March 2012 restructuring. The official justification for such treatment, announced in July 2011 as European creditor countries agreed to start restructuring discussions, was that the loans had been made for ‘policy purposes’. Moreover, the formation of the permanent European Stability Mechanism (ESM) in 2011 includes a form of ‘next-in-line’ preferred status. The “High Level Principles for Risk Management” in the ESM’s originating documents states that its “loans to member states will enjoy [preferred creditor status] in a similar fashion to those of the IMF, while accepting [preferred status] of the IMF over the ESM”. This next-in-line status of the ESM is, like the IMF’s one, a mutual understanding without specific legal status.
A final concern (unacknowledged at the time) stems from the potential for the preferred status to produce subordination risk for private or other official creditors. IMF support has two competing effects on a country’s risk profile:
- A risk-diminishing effect from providing a country with resources to continue servicing its obligations and from eliciting stabilizing policy changes; and
- A risk-increasing effect from the subordination of private obligations to the IMF’s preferred credits.
Generally, the former vastly outweighs the latter, at least in part because the size of the IMF’s financial commitment relative to a country’s total indebtedness is typically small. But as the IMF is drawn increasingly into capital account crises (as opposed to current account crises that dominated before the mid-1990s), this relative size effect is changing and with it the case for preferred creditor–unless there is a clear respect for a framework that ensures adequate programs (including up-front debt restructuring when necessary). In other words, subordination risk from an IMF loan must be outweighed by the confidence-enhancing effects of the agreed policy program for the status to make sense.
Whence discipline over IMF decisions: Rules or market?
The IMF’s preference is well-justified provided the IMF is a credible catalyst of market finance or, when market access has been totally closed down, facilitator of early return to market access. Direct IMF financial participation in funding a program (‘skin in the game’) enhances that credibility, and the preferred status provides protection for Fund resources should unexpected adverse developments derail the program.
Nonetheless, there is no way around the fact that the status can create moral hazard. By minimizing risks to Fund resources, it can influence decisions by members, motivated by political considerations, to provide support when actions to resolve the country’s crisis are not in place. Such was the case in the IMF’s decisions to waive its rules of engagement (the four criteria) in order to support Greece. Future resort to the waiver, by both undermining the credibility of the IMF and creating subordination risk, would constitute a reasonable case against preferred creditor. Some would argue that questions about the preference for the IMF have already started (Spink 2013).
Ultimately, the case for or against the IMF’s preferred creditor status comes down to how members choose to maintain discipline over IMF lending. There are two options:
- Discipline through rules, that is, a clear framework (such as the four criteria) specifying minimum standards for the credibility that IMF programs will return a country to market access; or
- Discipline through market forces, that is, subjecting IMF loans to the same risks of default or restructuring as private market lending–that is, by abandoning the preferred status.
Until the Eurozone crisis, the rules governing IMF policies provided a strong underpinning for the benefits of the status. The softening of those rules in the course of the Eurozone crisis weakens the case for the status. In view of the relatively strong track record of the pre-euro-crisis rules governing the IMF’s lending, it would be precipitous to abandon the preference on the basis of the IMF’s decisions in the Eurozone crisis alone. But the preferred creditor without a strong framework is a recipe for moral hazard. Should there not be a firm recommitment to a strong framework, the case for discipline through market forces will gain momentum.
Boughton, J M (2001), Silent Revolution: The International Monetary Fund 1979–1989, Washington, DC: IMF.
Catan, T and I Talley (2013), “Past Rifts Over Greece Cloud Talks on Rescue”, The Wall Street Journal, 7 October.
Cotterill, J (2012), “The Preferred, Puzzling, ESM ”, FTAlphaville, 3 February.
Martha, R S J (1990), “Preferred Creditor Status Under International Law: The Case of the International Monetary Fund”, International and Comparative Law Quarterly, 39(4), October.
Schadler, S (2014), “The IMF’s Preferred Creditor Status: Does it still Make Sense after the Euro Crisis? ”, CIGI Policy Brief 37, March.
Schadler, S (2013), “Unsustainable Debt and the Political Economy of Lending: Constraining the IMF’s role in Sovereign Debt Crises”, CIGI Paper 19, October.
Spink, C (2013), “IMF Set to Be Dragged into Greek OSI ”, Reuters, 10 May.